Wednesday, March 07, 2007

HIGHLIGHTS- Equity sell-off will have fleeting economic impact- 2007 GDP growth in Canada and the U.S. poised to accelerate

This is certainly a good week to take a step back andregain perspective. Nothing that happened in financialmarkets this week has caused us to change our outlookfor Canada, the U.S., or the global economy. Thecarnage in equity markets appeared to key off of anasty game of whisper down the lane in China onTuesday. The first person in line said “Beijing is thecapital of China,” and the last person in line swearsthey heard “Beijing is implementing a capital tax onequity gains of 20 per cent in China.” The governmentdid announce on Wednesday this wasn’t true, but ingeneral, Chinese authorities remain keen to reign inliquidity and prevent overheating. This is why theymade moves this week to shore up the stock market andwill continue to do so in the future. As in anyemerging market, Chinese equities will continue to besubject to growing pains and higher volatilitycorrelated more with regulatory changes than anyconnection with economic performance or prospects (SeeTD Economics special report on China earlier thisweek: http://www.td.com/economics/special/rk0207_china.pdf).

Because of this disconnect and its relatively smallsize, the Chinese stock market is not systemicallyimportant on a global scale. Rather, what we saw was areflection of the fractious debate regarding thefuture path of the global economy. Sixty per cent ofChina’s exports are foreign firms listed in exchangesoutside of China and 40% of the earnings of companieslisted on the S&P 500 originate from outside of theUnited States. For these reasons, evidence ofentrenched economic weakness in either economy wouldbe systemically important. While we continue tobelieve the U.S. and Canadian economies will coastthrough the current mid-cycle slowdown – and on thisaccount we are in the majority – there is still avocal minority of doomsayers. We do not discount theweaknesses these individuals point to. We simply don’tthink the outcomes they subscribe to are likely tohappen.

The Least Likely Outcomes

The Recessioniks are the largest minority. Theybelieve that the correction in the U.S. housing marketwill spread through to the rest of the Americaneconomy. Data on new home sales for January showedfurther weakness in the U.S. housing market, butexisting home sales – the larger market by far –unexpectedly improved. Concerns over sub-prime lendingare tied to the weak housing market. The sub-primemarket is a small percentage of total lending,however, and because interest rates are on hold atmoderate levels and there has yet to be anysignificant pullback in lending to prime borrowers,fears of contagion seem unwarranted. Taken at facevalue, larger than expected weakness in U.S. durablegoods and core capital goods orders would help tosupport the case for recession, as well. Both are asign that manufacturing activity may be slowing.Additionally, core capital goods orders serve as aforward indicator of firms’ investment plans. Butwhether you are in a recession or mid-cycle slowdown,investment always slows. In both cases, residentialinvestment tends to be the first to fall, followed bynon-residential investment. It is impossible todistinguish a recession from a fleeting economicsoftpatch looking only at investment data.

But the Recessioniks also point to Q4 GDP, which wasrevised down this week from an initial estimate of3.5% to 2.3%. The earlier figure certainly emboldenedmarkets to think the slowdown was over, but the lowerfigure dashed that perception. In fact, output growthis now in the range we thought we’d see at this stagegiven a mid-cycle slowdown. Moreover, the revisionswere the result of firms slowing their accumulation ofinventories. While this drawdown may continue in thefirst quarter, its implication for growth in thesecond half of the year is positive for production andinvestment once firms start to reload.

The Stagflationiks are the next minority. They sharethe Recessioniks concerns, but feel that a contractionin economic activity will be coupled with inflationarypressures ala the oil crises of the 1970’s. This wouldforce central banks like the Bank of Canada (who meetnext week but aren’t expected to make any changes) andthe Federal Reserve to raise interest rates in orderto maintain stable prices. The core PCE deflatorshowed consumer prices in the U.S. rose by 2.3%year-over-year since January. Prices are hovering justabove the Fed’s implicit range of 1.5-2%. But giventhe current global climate, any substantial economicweakness is much more likely to be coupled withdeflationary pressures, not inflationary ones. Ampleglobal liquidity has been fueling rapid investmentgrowth internationally, especially in China where itaccounts for nearly half of GDP. This is a lot ofproductive capacity which, if not needed, would leadto softening prices as producers try to movemerchandise.

The Most Likely Outcome

So this leaves TD Economics in the most likely camp –the Likeliniks. The most probable scenario given allthe information we have received to date is that U.S.GDP will continue to grow at a pace below 3% – butwell above the 0% and worse needed for a recession –and will accelerate into 2008 as housing, investment,and inventory weaknesses unwind. What is key for thisstory is consumer spending, which makes up two-thirdsof the economy. Consumer spending continues to trackthe path of a mid-cycle slowdown and is nearly a fulltwo percentage points above where it would be given arecessionary path (see graph). January’s U.S. personalincome and spending data showed consumer income was up1.0% while spending was up 0.5%. U.S. consumerscontinue to have the income to spend, they continue tohave the desire to spend, and with spending growingslower than income, consumers have even managed to cutback on borrowing.

The Canadian economy appears similarly poised toaccelerate. Although GDP growth for the fourth quarterof 2006 came in at a meager 1.4%, this was slightlyhigher than expected, and Q3 GDP growth was revised upfrom 1.7% to 2.0%. Moreover, monthly GDP growth forDecember of 0.4% points to a strong hand-off to thefirst quarter. Like in the U.S., inventories were alarge part of the story and represented a drag on GDPgrowth of nearly four percentage points. With a stronghandoff from December and the inventory overhanglargely unwound, Canadian GDP could come in for ashowing at or above 3% in the first quarter of 2007.

Alan Greenspan earlier this week said it is possiblethe U.S. economy could slip into a recession at somepoint in the future without any qualification of whathe meant. Saying the U.S. or Canadian economies couldslip into a recession is like saying an Olympicswimmer could drown in the deep-end of the pool. Is itpossible? Yes. Is it more likely than if he or she wasstanding in the shallow end? Of course. Is it the mostlikely outcome? No.